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of all guest columns written by Dennis C. Butler, CFA

Turmoil in the credit markets drew intense media focus during the third quarter as fears grew that a fiasco in the U.S. mortgage market would wreak havoc with the general economy. Doubts about the value of mortgages serving as collateral for various kinds of loans were at the heart of the commotion, as was the expectation that problems with low quality loans — already a serious issue — would rise sharply owing to the “reset” features of many adjustable mortgage products, and a spreading downturn in real estate values. Add to the mix the high debt levels of some financial players and the stage was set for a panic. Thanks to recent financial market innovations the crisis quickly became an international one, as illustrated by the dramatic (and controversial) rescue of a small German bank that had gotten in over its head in U.S. mortgage securities. Soon monetary authorities in the U.S. and Europe were forced to inject hundreds of billions of dollars into the international banking system in order to counteract a paralysis in critical short-term lending among banking and other institutions.

Meanwhile, noticeable volatility returned to stock markets, and commodity prices rose, with some—notably crude oil and wheat — advancing to record levels. The U.S. dollar weakened considerably, falling 5% against the Euro during the three months to new lows against the common currency. There began on Wall Street (where not only jobs but bonuses were at risk) an urgent call for the Federal Reserve to cut interest rates immediately. The ostensible reason was to prevent the real estate downturn from damaging the overall economy, although we can’t help but think that the need to raise over $300 billion to cover loan commitments made by investment banks during balmier times played a role. Lower rates and calmer markets would certainly make that task a whole lot easier.

While sometimes dramatic in terms of index point changes, the volatility in stocks needs to be put in perspective. Much of what we have seen represents a return to more normal ranges of price fluctuation after an extended period of unusually calm conditions. Seen in this context, one to two percent daily moves in the indexes (or roughly 140-280 points on the Dow Jones Industrial Average as it now stands) are nothing to get excited about. Three to four percent changes (420-560 Dow points) also occur from time to time. The granddaddy of all one-day plunges — the 22% decline in October 1987— would translate into about 3100 points down today; we’ve experienced nothing even close to this for twenty years. Public perceptions of stock market moves are also skewed by a persistent media bias which places a positive slant on ascending stock prices. Thus a 0.5% gain may be described in terms like “stocks rose moderately,” while a similar move to the downside elicits “stocks plunged today.”

The financial drama of recent months could conceivably be viewed as heralding the long-awaited “repricing of risk” foreseen by some observers of the markets. Not only had prices of financial assets in general been elevated relative to historical averages, the markets had not sufficiently distinguished between assets of varying quality (akin to WalMart selling clothing at Neiman Marcus prices). Despite the market hullabaloo, it is questionable how much repricing has actually taken place. A look at the statistics for the quarter is revealing. The Dow Jones average gained 3.6% during the period. The NASDAQ rose a similar amount, while the S&P 500 was up 1.6%. Year-to-date, all three averages were up significantly. Foreign markets also did well, with China and India, among others, hitting records. While many individual stocks lost value (about 40% of New York Stock Exchange companies are down for the year), it hardly seems like a “crisis” from the stock market’s perspective.

In fixed income, a so-called “flight to quality” caused yields on U.S. government securities to drop significantly: the “benchmark” 10-year note dropped about 0.5% to 4.6% at quarter’s end; the 2-year fell nearly 1.0% to just under 4.0%. Spreads widened, but mostly by very small amounts, and remain well below average. The flight from poor quality did actually cause some sectors of the credit markets to freeze up this summer — commercial paper and “high yield” were hard hit, for example. Mortgage-related securities and some of the more exotic derivative creations are still hard to market. Wall Street got its wish, however, and the magic of a couple of Federal Reserve rate cuts rekindled the appetite for risk somewhat. In fact, during September, high yield bonds staged their biggest recovery since 2003, and toward quarter-end the Street began to move out junk paper related to buy-out deals. For high quality issuers the turmoil has been a non-event. In fact, they probably benefitted from an undiminished search for yield at lower risk tolerances, and continued to raise large amounts of capital at relatively low cost; corporations issued debt at a record pace in September. The so-called credit crisis seems limited, and confined mostly to poorer quality borrowers and the specialized lenders who serve them.

Gobs of capital looking for a home continue to characterize the financial markets of our time. Whether in oil-producing nations, Asian exporters, or the industrial West, wealth continues to mount. New “sovereign wealth funds” set up to invest the accumulated reserves of these regions total about $2.5 trillion, and even this large sum is but a fraction of the total. All of this wealth acts to stabilize and raise valuations in the markets for securities world-wide. Such is the demand for new investment vehicles that new funds are now being organized to buy up the distressed securities resulting from this summer’s rout in the credit markets, something that relatively obscure “vulture funds” did in the past. It appears that for the time-being, only temporary dislocations, such as that caused by indiscriminate hedge fund selling in August, can upset prices, and then only briefly, and usually by insignificant amounts. Bargains in this environment are still hard to come by.

Moral Hazards and Speculation

Sometimes it appears that the cash-to-brains ratio in certain areas of what is customarily called the investment business is extraordinarily high. For example, hedge fund clients are supposed to be wealthy, sophisticated types who understand that the price of achieving outsized gains or avoiding market downturns (i.e., the raison d’etre of hedge funds) is the possibility of an occasional large loss. Theoretically, a poor year should be more than offset by periods of supersized returns. It is noteworthy, therefore, that so many of the financial elite have been clamoring to exit their hedge fund commitments at the slightest hint of poor results (perhaps because they are aware that some of their fellows have suffered huge, irrecoverable losses).

High cash also appears to overwhelm smarts on the other side, among fund managers, who have every incentive to enter into situations that increase the probability of massive losses. Earning generous fees and potentially lucrative bonus payments (“2/20” is the usual arrangement — 2% of assets under management, plus 20% of profits), these professionals can acquire wealth very quickly if their bets are successful. Losses, on the other hand, are borne by the investors in their funds. These arrangements, in which fund managers have everything to gain and nothing to lose (except, perhaps, their reputations) constitute what is known as a “moral hazard” and create troubling conflicts of interest. Where fund managers are immune from losses and feel they can “play” with other people’s money, the result is a “go for the gold” mentality leading inevitably to speculation and inordinate risk-taking. The effect is multiplied when thousands of such managers operate in competition with each other. Hence we see funds taking big bets and getting involved with the most exotic and risky creations that Wall Street can devise. Typically the amount of “leverage” (borrowing) employed in these operations matches the level of risk and size of manager egos. The big blow-ups we have seen over the last year involving hedge funds have been characterized by huge misplaced bets on things such as natural gas contracts or, more recently, complex derivative securities involving real estate loans, in which literally billions of dollars have been lost in the twinkling of an eye.

There is no doubt that a small number of these trading operations work as advertised and produce results commensurate with the risks. By and large, however, 2/20 is not a business model that is conducive to client wealth-building. Aside from the potentially deleterious impact on clients, the effect on financial markets should also be considered. Over five billion shares traded on the New York Stock Exchange on a single day at the height of the market’s swoon in August. Much of that activity was due to a heightened level of speculation encouraged by trading funds of various kinds. Speculation in itself is not necessarily harmful (except to those who practice it), and it even has economic benefits. It is when it becomes the name of the game that we have to worry. As Keynes once observed: “Speculators may do no harm on a steady stream of enterprise. But the position is serious when enterprise becomes a bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.” The dot-com demise, the impending collapse of ethanol producers, and the imploding real estate bubble — all areas of speculative excess at one time or another — are the results of capital development “ill done.”

In closing we point out that the term “moral hazard” has become something of a buzzword in recent months. The Federal Reserve has been accused of creating a moral hazard through its interest rate reductions and liquidity injections in August and September. Such policies, it is argued, enable Wall Street speculators to escape the consequences of their actions. Both the U.S. and U.K. central banks have come under fire for bailing out or otherwise insulating banks from the inevitable results of poor mortgage lending practices. Banks themselves, instead of lending money, now are often no more than “originators” of loans to sell on to investors. Banks, whose objectives now are volume and profits, not profitable loans, are incentivized to make loans regardless of quality. Finally, a history of Federal Reserve actions to support the markets and economy has led the risk-taking crowd to take comfort in the belief that the “Greenspan Put” will operate to bail them out of bad decisions should the threat to the markets and economy become too great.

Following a poor year, the forerunners of today’s hedge funds forwent compensation until their clients’ losses were recovered. Having “skin in the game” dampened speculative impulses and fostered greater care with other people’s money — the very opposite of a moral hazard. Would that this arrangement were more common today. Those who knowingly take risks should accept the consequences. Speculators usually lose, and that is how it should be.

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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation,
investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in
Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at: